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Is ETF Growth Good For Gold Bugs?

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The growth in exchange-traded funds has made it easier for mainstream investors to access the yellow metal. How is that impacting the market?

We have recently received a number of questions regarding our view of gold.

Against the backdrop of one the most challenging stock and real estate markets in decades, gold is garnering an increasing amount of attention. In the investing world, it is regarded by some as an inflation hedge, protection against an Armageddon scenario, and a potential store of value against depreciating currencies.

The breakdown of gold’s demand can be seen in Figure 1 (courtesy of World Gold Council). The table shows jewelry and industrial demand for the precious commodity declined in 2008 relative to 2007, but that weakness was more than offset by a notable increase in investment demand, such as Bar Hoarding (+60% growth 2008 vs. 2007) and Official Coins (+44%).

In addition, there has been a great deal of investment demand driven by the advent of exchange traded funds (ETFs), which has made it easier for individuals to invest in the precious commodity. Demand for Gold ETFs and the like showed a 27% increase from 2007 to 2008; growth has continued to accelerate in the early part of 2009. As recently quoted in the Wall Street Journal: “Trusts have added 306 metric tons of gold to their vaults in the first seven weeks of the year, says Barclays Capital Analyst Suki Cooper. That's just short of the 322 tons added in all of 2008. If that rate were to continue, this year's ETF purchases would surpass the 2,120 tons procured for jewelry in 2008, replacing it as the top source of demand.”

Figure 1. Breakdown Of Identifiable Gold Demand (Tonnes)

Since gold neither pays a dividend nor generates cash flow, we have never felt a great comfort in assigning a fair value for the precious commodity. Often, in our opinion, its direction is driven primarily by investor psychology and it trades on momentum, which is a double-edged sword.

Due to the difficulty in determining a fair value, we tend to look at gold from a technical/chart perspective. The SPDR Gold Trust (symbol: GLD), which is an exchange-traded fund, is one way investors can invest in gold. The investment objective of the Trust is for the shares to reflect the performance of the price of gold bullion less the expenses of the Trust's operations.

Since the November lows, the GLD has been in a steady uptrend, making a series of higher highs and higher lows. However, the security has faced some near-term selling pressure after approaching its March 2008 high around $100 (Figure 2).

So far, the recent 10% correction looks to be a normal pullback, with the intermediate and longer-term upward trends still in tact. The GLD appears to have support (where investors could potentially step in to buy) in the band of $84.50-$88 area; this is also where the 50-day ($88) and 200-day ($84.50) moving averages currently reside.

A break below these support levels would be viewed as negative from a technical perspective. The greatest near-term risks we see is investors gaining greater confidence in the economic outlook and possibly equities, which could lead to rotation out of safe haven securities, such as gold.

For investors interested in obtaining exposure to gold, we believe the recent pullback offers a reasonable entry point from a risk/reward standpoint. That said, because it is difficult to determine a fair value for the precious metal, and its fluctuations are largely driven by emotion and momentum, which can turn on a dime, we believe it is important investors have a strict sell discipline. Depending on one’s risk tolerance, investors might consider placing a downside stop either at $82.90 (slightly below the 200-day moving average) or $77.30 (slightly below the January price low).

“The SPDR Gold Trust (GLD) is classified as a grantor trust, for US federal income tax purposes. As a result, the Trust itself will not be subject to US federal income tax. Instead, the Trust’s income and expenses will “flow through” to the Shareholders. All Shareholders should contact their own tax advisors as to the tax consequences of the SPDR Gold Trust.” https://www.spdrs.com/library-content/public/SPDR_Gold_Trust_2008_Tax_Information.pdf